Continued from Part 1

In addition to that Fed is now facing another trade-off- trying to protect as many banks as possible from the insolvency and buying them some more time with lower rates, and at the same time trying to contain the increasingly unstable inflation expectations from spiraling completely out of control.

11. In my opinion, achieving both objectives is at this point virtually impossible and thus Fed could either:

• Own up to its mistakes, raise interest rates swiftly, bankrupt many of the smaller and mid size banks, but kill the inflation genie and deflate the commodities bubble. In the process this will send the entire global economy into a deep but relatively short lasting recession - shape "V" as the media would say...:)

• Keep talking "big game" but not take any "real actions". Force banks to raise more capital by diluting existing shareholders and cutting dividends whether they eventually need it or not. Keep rates low and pump more liquidity in, until commodities or some other bubble, once again blows out of proportion. But inflation in this scenario is very likely going to enter the next stage of a usual cycle -with workers demanding higher wages in turn moving prices even higher etc... Eventually Fed will be forced to raise rates higher than in scenario 1 and thus will inevitably send the economy into a more severe recession- shape "W" as the media would say. (Inflating the housing issues away should allow for the headline GDP to contracts only slightly in the first leg of the cycle).

12. Neither one of the options is pretty at this point, but in my opinion while the first one is clearly the more logical, it is also very politically challenging- with election season in full swing- rates will be tough to raise without a republican "blood bath"... So Fed is going with the option two -which in turn means that because regulators are now going into a severely brutal "raise more capital at all costs" mode, even the healthy bank's shareholders are now bracing for more dilution.

13. Thus my decision to buy into financial sector last week even in a small way was not a correct one and I am reversing it. It also means that S&P and DOW could very well retest/ move past the January lows in the nearest future and thus adding a few more shorts and more defensive play like utilities might not be such a bad idea.

On the positive side, however- the corporate health outside the financial and consumer discretionary sectors still looks ok and income tax withholdings as released by the US Treasury http://www.fms.treas.gov/dts/ have actually picked up in the last few weeks of May and in early June. The most recent data in my interpretation is consistent with a GDP growth of at least equal to or may be even slightly higher than that in Q1 2008...

After playing with the data I have also found what seems to be an interesting correlation between the four weeks lagged S&P 500 index and growth in withholdings- it is by no means bullet proof, but certainly seems to point to a limited short term S&P downside (2-3%) with the next move up of roughly 5-6%.

And to finish off- here is one more opinion- I think that behind the all the "doom and gloom" noise out there, it is important to clear any disillusions and fears. In my opinion, 10 years from now- all major US indices will be trading at higher nominal prices than they are trading today, period. I am willing to make this bet with pretty much anyone-but I also doubt there will be many takers though as it is pretty much bound to happen for two main reasons:

1. In the world of "fiat" money inflation is not going away and thus while real stock prices might be higher or lower, nominal prices are simply destined to go up!

2. US Economy is still the most vibrant, flexible and productive one in the world and thus it will find a way to reinvent itself and will surely grow in the real terms again at some point :)

So with that in mind, I think that assuming one could weather some serious volatility in the next 12-24 months or so- pulling all the money out of stocks and reinvesting them in cash or money market funds is very likely to be the most counterproductive thing a passive investor could do. However, protecting the principal investment should be the most important goal of any investment manager and thus hedging with short positions is as usual a very prudent decision...

Stay safe out there, skepticalcapitalist@gmail.com